Lessons from the financial crises:

23 Jun 2009, Published in Economic Times, Arun Duggal, (Former CEO-India of Bank of America)

These are difficult times. Bankers, including former bankers like myself, are in deep trouble. And deservedly so. We are the main, (though not the only) culprits in creating the current massive financial crises in the world. No one has ever accused bankers of being particularly bright or hardworking or reliable. Remember the guy who lent you an umbrella in fair weather and took it back when it rained. But now with their oversized bonuses under public scrutiny, bankers reputation has touched new lows, somewhere between bandits and thieves.

Even though publics anger against bankers and AIG executives is justified, the important thing is to learn what mistakes were made, and reform the system to prevent their recurrence. Even more important is to take the right lessons from the crises and not the wrong one. In months and years to come, there would be a great deal of analysis on what caused the current financial crises. However, there is a fair degree of consensus that extreme excesses in the following areas contributed substantially to it:

In the US, too much money was lent to consumers, far beyond their ability to repay. Consumer credit which used to be 100- 150% of the GDP for most of the last century shot up to 300% in the last 10 years. Size of the banking sector as a whole and individual banks became too large and very highly leveraged. As Simon Johnson, former chief economist of IMF, notes in a recent article in The Atlantic, the financial sectors profits which used to be around 16% of the total US corporate profits increased to 41% in recent years. Similarly the size of the banking sector in relationship to domestic economy in countries like Iceland, UK and Switzerland became excessively large.

Too many complex financial products were created and distributed. The real risks of these products were not understood by the bankers, rating agencies or the investors. The structured products creators and marketers within the banks became too powerful and the risk managers too weak, so there were no checks and balances. Bankers were paid too much. We have heard about the obscene bonuses being paid to bankers and AIG executives in the US. Even closer home, in 2007, IIM graduates were getting offers of more than a crore per year from international banks, multiple of what their learned professors are earning.

US treasury secretary Tim Geithner in his testimony to House Financial Services Committee said, I share the anger and frustration of the American people, not just about the compensation practices at AIG and in other parts of our financial system, but that our system permitted a scale of risk-taking that has caused grave damage to the fortunes of all Americans.

To avoid this in future, policy makers should consider the following actions based on the lessons learnt from this financial crises: One, the size of the banks should be restricted, so that some of them do not become so big as to endanger the entire financial system. Their activities should be restricted too. They should not be allowed in the investment banking or securities business. Two, banks all over the world should become a utility to serve the national economy under supervision of the local regulator. Their global expansion should be curbed. In order to support international trade and capital flows, international banks should be allowed to invest overseas, but only as minority investors. The local regulators should keep a close watch so that troubles in the home country of an international bank does not result in contagion.

Three, the central banks must act to prevent bubbles. They should expand their focus to control asset price inflation in addition to consumer price inflation. They should take corrective steps if there is excessive credit growth overall and in any particular sector of the economy. Four, the capital adequacy requirements of banks and other financial institutions should be further increased. Banks should adopt dynamic provisioning policy, (as in Spain) to provide higher credit provisions and reserves during strong economy, which will act as cushion during recession.

Five, banks should not be allowed to accumulate any risk through off balance sheet structures. All risks must be included in ascertaining capital adequacy. Innovation in banking should be encouraged, but in areas such as use of technology and other means to serve its customers better. In India and in most developing countries innovations should target to include the unserved or under-served population into financial system. Six, the whole system of creation and distribution of structured products needs overhaul. Banks should be asked to keep at least half of the assets created by them on their books so that the bank managements are well aware of the risks they are accumulating and distributing.

Similarly the rating agency system needs major correction. Perhaps they should have their skin in the game and not only earn fees and then wash their hands off. Let them also keep 10% of the paper they rate on their books until it matures. It will concentrate their minds to understand and evaluate long-term risks appropriately.

Seven, and perhaps the most important, the compensation of bankers and the risk management in banks require a thorough revision. Bankers compensation must come down and be in line with what other professionals earn. The bonuses should be downsized and linked to various performance parameters. Private equity offers a good model of longterm incentives: they make money (carry) only if and after their investors have made money. The risk management systems in the banks should be strengthened. While this should be the primarily job of board of directors of banks, the regulators should monitor compensation practices in banks.

This would encourage our best and brightest young people not to chase banking careers and do real work as engineers, scientists, scholars, social workers, etc. As Paul Krugman wrote recently, Banking should become once again a boring business.